Reverse Converts: A Nest-Egg Slasher?

By

Larry Light

Updated June 16, 2009 11:59 p.m. ET

Like the nemesis from an old slasher movie, reverse convertibles are the investment that won't die.

Not long ago, these bond-like securities, which morph into stocks when the underlying share price plunges, were the rage. Investors in 2008 bought almost $7 billion of reverse converts, as the securities are known in Wall Street parlance. But stocks' slide late last year and early this year left thousands of investors with steep losses.

ENLARGE

Lawrence Batlan, seen at his Clifton, N.J., home, lost almost 20% on his investment in reverse convertibles.
Emile Wamsteker for The Wall Street Journal

Despite a dismal track record, Wall Street is once again pushing reverse convertibles because they throw off such juicy interest payments. Now that stocks are up again, the hope is that investors will forget and the market will cooperate to enhance the amnesia.

Large banks such as Citigroup Inc.,C-0.71% Barclays PLC and ABN Amro Holding NV are issuing new ones lately, albeit not as many as last year. Citi, for instance, has just brought out new versions linked to the likes of Apple Inc.,AAPL-0.87%Celgene Corp.CELG-0.48% and Johnson & Johnson,JNJ0.37% paying around 11% over one year. The issuing banks score generous fees, often 2% and up.

Reverse convertibles are short-term bonds that are coupled to well-known stocks and often pay double-digit yields. Once the notes mature -- their terms generally last from three months to a year -- investors get their principal back. Yet if the underlying stocks plunge to a certain point, called the "knock-in" level, usually 20% to 30% down, investors get the shriveled stocks in lieu of the full principal.

That is what happened to Lawrence Batlan, an 85-year-old retired radiologist, who suffered a loss of almost 20%. He says his broker talked him into shifting out of preferred stocks in 2007 and buying $400,000 of exotic securities, which promised higher interest and safety.

Linked to four well-known stocks, they paid between 6.25% and 13%, at a time when 10-year Treasurys were yielding around 5% yearly. Along came the bear market, and the share prices for the quartet of underlying stocks slid below the 20% knock-in threshold. Suddenly, Dr. Batlan and his wife, Frances, found themselves the unproud owners of Hess Corp.HES-2.19%, Yahoo Inc.,YHOO-2.00% Mexico's Cemex SAB and SanDisk Corp.SNDK-0.43% stock, worth $75,000 less than they had invested.

"I had no idea this could happen," says Dr. Batlan, a resident of Clifton, N.J. "I have no desire to own Yahoo stock or the others." He has filed a complaint with the Financial Industry Regulation Authority, or Finra, in a bid to get the $75,000 back from Citi, which has declined to comment on the pending case.

Reverse convertibles, which originated in Europe in the 1990s, were first marketed to the U.S. market around five years ago, aimed at small investors. Stock prices were rising, so the downsides didn't emerge. With low minimum investments, typically $1,000 apiece, and the nice yields, reverse convertibles initially had a strong sales run -- almost doubling in 2007, to $8.5 billion, from the previous year.

Sales of the securities so far this year are under $1 billion. That is down two-thirds from the comparable period in 2008, says the research firm StructuredRetailProducts.com.

"I was told there was no risk with these," says Harvey Goodfriend, 77, a retired mechanical engineer living in Simsbury, Conn. He complains that he lost 36% of the almost $250,000 that his Stifel Nicolaus & Co. broker sunk into reverse convertibles two years ago. Stifel didn't respond to requests for comment.

Critics of reverse convertibles say it is telling that sales for these securities are focused on retail investors, not financial sophisticates, and use the tasty interest as a come-on. "Why are they offering you this great deal?" asks Larry Swedroe, research director at the Buckingham Family of Financial Services. "Do you think they like you?"

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